Making the case for more active central banks
I have been banging on about the lack of evidence that inflation expectations matter for inflation for quite some time now. My latest missive on that subject can be found here. But many investors and rate setters at the Federal Reserve and the Bank of England alike keep on emphasising the important role expectations play in the fight against inflation. If expectations rise, particularly the 5-year inflation expectations in 5 years from now – the Fed’s favourite measure of expectations – markets get fearful of further rate hikes and start to drop.
A new paper by Ivan Werning from MIT examined different sophisticated inflation models to check if expectations realty matter for future inflation. It is a highly technical paper, but because I am such a good person, I have gone through the trouble of reading it, so you don’t have to. You can thank me later. Boxes of Swiss or French chocolate are gratefully accepted.
He found that the typical assumption made in inflation models that expectations pass through to future inflation almost one for one (i.e. 1% higher expected inflation leads to 1% higher inflation in the future) is not supported by the data. In fact, the pass-through rate is probably much smaller than that and can plausibly be zero. So far so good. Nothing new there.
Where his paper gets interesting is when he checks what kind of inflation expectations influence future inflation. There, he finds that short-term inflation expectations can influence future inflation as firms and households change their behaviour in pricing goods and services and paying for them. But he finds no evidence that long-term inflation expectations matter at all. A lot of the success story of central banks over the last thirty years or so rests on the assumption that it was the anchoring of inflation expectations that created low and stable inflation. And now Werning finds that none of that matters at all.
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Meanwhile, short-term inflation expectations seem to matter. This presents a case for central banks to become more active in fighting inflation in the future. Short-term inflation expectations are far more volatile than long-term expectations but if they are the ones that have the potential to drive inflation, central banks need to react to rising inflation far quicker than they have done in the past. It would mean a very rapid increase in interest rates at the first signs of inflation rising above a certain threshold. And it would mean that central banks made a cardinal error in letting inflation run higher in late 2021.
This kind of thinking is also supported by an interesting study of private households in the US. That study found that US consumers mostly ignore inflation as long as it is lower than 2% to 4%. If inflation is that low, we act as if inflation is essentially zero. But once inflation becomes salient and large enough to feel in daily shopping expenses, consumers adjust their inflation expectations upwards. Suddenly, they project prices forward with the current inflation rate and change their consumption pattern accordingly. Again, it is short-term inflation expectations that change consumer behaviour not long-term expectations. And it requires central banks to keep inflation well anchored in the short-term because even a relatively short period of high inflation changes the behaviour of consumers which in turn influences inflation, etc. Breaking that spiral needs to be done quickly and requires a more active and aggressive central bank than what we have become used to in the last decades.
But that also works the other way round. If inflation is too low, it would require quick and aggressive rate cuts to levels that could be far below zero. QE and the monetary measures we got used to over the last 15 years would not be enough. Central banks would potentially have to literally put money into people’s bank accounts to quickly create inflation and prevent short-term expectation from moving down too much. And I doubt that the public would be on board with that kind of activist monetary policy.